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Dividends Provide A Return Bonus

With all things being equal, dividend paying common stocks
provide their shareholders a return bonus, or what some might like
to call a kicker, over an equivalent common stock that pays no
dividend. Many investors do not see it this way, as they tend to
think of the dividend providing them their return. However, the
stock market capitalizes earnings whether a company pays a dividend
or not. Moreover, we contend that the market will value a given
company's earnings based on their past and future prospects for
growth, again, regardless of whether a dividend is paid or not.

To clarify our point further, an investment in a common stock
typically offers their shareholders two components of return. The
first component is the capital appreciation component or the
increase (or decrease) in the stock's value over time. The second
component is the dividend, or lack thereof, that the company pays
to shareholders in cash, typically once a quarter. The two added
together equal the shareholders' total return. On the one side, we
have the capital growth component and on the other side the income
component.

Now, here is the primary point behind this article. If you
examine two companies with equivalent rates of earnings growth,
where one pays a dividend and the other does not, the dividend
payer will provide their shareholders a higher total return. In
other words, we're suggesting that both stocks will provide
equivalent capital appreciation when measured over a time period
when the market is behaving rationally. We would define this as a
time period when both stocks were being priced at fair value in the
beginning and in the end. Consequently, the stock that pays a
dividend to its shareholders is providing them a return bonus or
kicker.

What we are about to say next may come as heresy to the devout
dividend growth investor. Nevertheless, the facts speak for
themselves and we ask that they try to look at the total picture
with an open mind, and eyes. In either case, dividend paying or
not, the bulk, or majority, of total return will be provided by the
capital appreciation component. This is why we are saying that
dividends are a kicker or bonus return. In other words, capital
appreciation is the cake and dividends (if any) are the icing.

As a point of further clarification, this principle applies to
the true dividend growth stock. We would define a true dividend
growth stock as a company that has historically grown earnings at
an above-average growth rate, and is expected to continue growing
earnings at an above-average rate in the future. To clarify even
further, low growth dividend paying stocks like utilities will
often provide their shareholders the bulk of their returns through
dividends. This is due to the low growth nature of their earnings
which typically leads to subpar capital appreciation.

(If you would like to test this last statement regarding
utilities,
follow this link
to Addendum To - Investing in Eastern Utility Stocks - Do Today's
Valuations Make Sense, Part 4)

A Picture Is Worth 1000 Words

To illustrate the validity of the thesis behind this article, we
are going to once again rely on our graphs' earnings, price (and
dividends) correlated research tool. This powerful "tool to think
with" was designed to graphically, and therefore, instantaneously
portray the important principles underlying the total return that
shareholders can expect from a given common stock. More
importantly, they were designed so that each of the two components
of return, capital appreciation and dividend income, could be
visually exposed independently and therefore, returns easily and
quickly calculated.

The Total Return Component

The total return component is driven by the market pricing a
company according to its earnings achievements. Therefore, the
orange earnings justified valuation line on each of the following
graphs represents what we call the True Worth™ or what others might
call the intrinsic value of each sample company, again, based on
the market capitalizing its
total earnings
. Simply stated, when the black monthly closing price line touches
the orange earnings line, fair value is present.

Focusing on this earnings and price relationship will provide an
instantaneous perspective of capital appreciation as long as fair
value is present in the beginning and the end. All that the reader
has to do is look immediately to the right of each graph to find
the company's earnings growth rate listed and use it to easily
estimate returns.

Consequently, without any mathematical computation, the reader
should understand that the capital appreciation component will
precisely equal, or at least closely correlate, to the company's
earnings growth. Therefore, when price starts on the orange line
and is on the orange line at the end, whatever the earnings growth
rate is, the capital appreciation will also be (within minor
valuation adjustments).

In order to demonstrate this as clearly as possible, we had to
carefully pick historical time frames where earnings and price were
correlated (the price touching the orange line) both at the
beginning and at the end. Although we could not do this with
absolute precision, as you will soon see we were able to accomplish
it within reasonable margins of error.

In other words, the price and earnings relationships we are
showing are not perfect matches, but very close. However, in order
to carry out this objective with the examples chosen, we had to
draw some of our charts where we ended them through calendar
year-end 2011 because valuation was in alignment at that time
(thereby eliminating any 2012 data points). This was done in order
to visually articulate the principle that we are hypothesizing.

The Dividend Income Component

Interestingly enough, the dividend income component is also
driven by and is a function of the company's earnings achievements.
Even though dividends are paid out of earnings, we intend to
demonstrate that the market eventually capitalizes the full measure
of the company's earnings even though a portion has been paid out.
Therefore, the dividend component becomes, as our thesis indicates,
an extra or bonus piece of return.

In order to depict this as vividly as possible, we chose to
illustrate the full measure of each company's earnings (the green
shaded area with the orange line on top) and then illustrate the
dividend component separately. Therefore, we calculate the
dividends paid out of earnings (light blue shaded area) and show
them as additional return by stacking them on top of the green
shaded earnings area on the graph (Note: The orange line represents
the fair value of the company's earnings, while the green shaded
area represents the total earnings). We believe this serves as a
constant reminder that even though dividends come out of earnings,
the capital appreciation component of the dividend paying stock is
not reduced or diminished by the dividend.

A quick word about ex-dividend dates are in order. Although it
is true that a company's stock price will fall at precisely the
level of its declared dividend, this is only relevant for that
brief moment in time. In any other time during the quarter, and
usually almost immediately following the ex-dividend date, the
company's stock price will be once again capitalized based on its
total earnings. In other words, over the majority of the time that
a dividend paying stock trades, their shareholders' profits are not
penalized by dividends. Therefore, and in truth, the dividend
provides additional return above and beyond the company's earnings
growth.

Examples Of The Dividend Bonus

Before we move on to presenting specific graphical evidence of
our thesis that dividends are a bonus, a few qualifying remarks are
in order. As previously alluded to, this article focuses on
dividend growth stocks, which we define as dividend paying
companies with above-average earnings growth. Therefore, we will be
primarily presenting companies with above-average, to significantly
above-average, historical total returns and earnings growth rates.
It is from this class of dividend paying stock where the majority
of return comes from growth of principle.

On the other hand, even for low growth dividend paying stocks
such as utilities, the capital appreciation component is often low
because of the low growth rate of the company's earnings. (If you
would like to test this last statement regarding low growth
utilities, follow
this link to
Addendum To: Investing in Central Utility Stocks, Do Today's
Valuations Make Sense, Part 3.)

Furthermore, the dividend component is usually above-average
with utility stocks, so cumulative total dividend returns may be
equal to or even exceed capital appreciation. Nevertheless, the
principle that dividends represent a bonus return remains
valid.

Our first set of examples compares two very fast growing
businesses with one paying a dividend and the other not. Our
nonpaying example is Hibbett Sports Inc. (
HIBB
), a sporting goods store operating predominately in the Southeast,
Southwest, Mid-Atlantic and Midwest regions of the United States.
As we can clearly see by the earnings and price correlated graphic
below, the company's earnings growth rate (the orange line) has
averaged over 19% for the years 1998 to 2011. But most importantly,
we see that the market has priced the company in accordance with
its earnings growth. Note the lack of a dividend as highlighted at
the bottom of the graph (also no light blue shaded area on
graph).

Just as we saw in our first example, the market has capitalized
the full measure of FactSet Research Systems Inc's earnings just as
it did for Hibbett Sports Inc. However, our attention is
immediately drawn to the light blue shaded area or dividends. Since
the company's price was close to the earnings line at the beginning
and at the end, we can assume that capital appreciation should
approximate the 20% plus earnings growth rate. But the key point
behind this article is to note that dividends provide returns that
are in addition to price appreciation as depicted by the light blue
shaded area.

(click to enlarge)

Next let's examine the total return performance of each of our
two samples. Our first example, Hibbett Sports Inc, grew earnings
at 19% and therefore, generated capital appreciation at 18.2% that
was a close approximation to its earnings growth rate of 19.3%.
Note that there are no dividends or dividend cash flow table
listed. This is another design feature of the F.A.S.T. Graphs™
research tool.

A $1000 investment made on December 31, 1997 would have
purchased 230 shares of Hibbett Sports Inc. at $4.35 per share. By
December 31, 2011 the price of the stock had appreciated
approximately ten-fold to $45.18 per share. This turned a $1000
investment into $10,391.40 for a compounded annual rate of return
of 18.2% per year, which again, was although just under but closely
approximating the 19% earnings growth rate. Even without a
dividend, Hibbett Sports Inc. generated shareholder returns that
were significantly higher than the average company as measured by
the S&P 500.

(click to enlarge)

Now, as we turn to our dividend paying example, FactSet Research
Systems Inc., we discover a more complex performance record. We
still discover that a $1000 investment on December 31, 1997 would
have purchased 146 shares at a price of $6.83 per share. Then, just
as we saw with our first example, the share price on December 31,
2011 grew to $87.28 per share. Thereby generating a capital
appreciation component, that is more than twelve-fold larger than
our original investment.

Interestingly, our dividend paying, and therefore theoretically
more conservative stock, actually grew faster notwithstanding the
fact that it was paying dividends. This explains the greater
capital appreciation component with FactSet Research Systems Inc.
However, we further discover the dividend cash flow table which
clearly illustrates the impact, and the additional rate of return,
that shareholders received through dividends.

(click to enlarge)

With our next two examples we will look at a slightly shorter
time frame covering the eight-year period calendar years 2004
through 2011. Once again, our sample companies in the time frames
covered were specifically chosen because they clearly illustrate
the reality behind our thesis that dividends represent a bonus
return to shareholders. To repeat, if you have two companies with
approximately the same rate of earnings growth that are purchased
at fair value, and one pays a dividend, its shareholders will
receive a bonus return over shareholders of the non-dividend paying
or otherwise equivalent company.

O'Reilly Automotive Inc. (
ORLY
) is a fast growth automotive aftermarket parts and tools retailer
that grew earnings at a rate of 19.5% per annum between 2004 in
2011. Clearly, we see that the company's stock price has tracked
its earnings growth, and anytime when the price moved above or
below the earnings line it quickly returned. However, the important
point is that the market capitalized the full measure of the
company's earnings in the long run.

(click to enlarge)

Consequently, shareholders of O'Reilly Automotive Inc. enjoyed a
return over this eight-year period of time that was virtually
identical to the company's earnings growth rate. But since there
were no dividends being paid, only the capital appreciation
component applies.

(click to enlarge)

Our next example, McDonald's Corp. (
MCD
), also enjoyed very fast earnings growth of 17.7% from 2004 to
2011. However, we see by the light blue shaded area on its graph
that they also paid their shareholders a nice dividend. With this
graph we can clearly see a visual example of how dividends
represent an extra, or bonus, rate of return. The stock price very
closely tracks and correlates to earnings with the price close to
touching the orange line at the beginning and only slightly above
the orange line at the end.

Therefore, once again we see undeniable evidence that the full
measure of McDonald's earnings are being priced by the marketplace.
If dividends do not represent additional return, then it would
logically follow that the normal PE ratio (the dark blue line)
would be below the orange earnings line illustrating that the
market did not price the portion of earnings that were paid in
dividends. Instead, we see that both the orange earnings justified
valuation line and the blue normal PE ratio line are almost
perfectly coinciding.

(click to enlarge)

Now as we examine McDonald's performance, we find capital
appreciation slightly exceeding earnings growth due to the very
modest overvaluation at the end of the period. However, and most
importantly, we see that dividends in this example contribute
additional return.

Just like we saw with O'Reilly Automotive above, McDonald's
shareholders received the full value of their earnings growth from
the marketplace. Furthermore, their dividend payments representing
a portion of earnings paid out to shareholders, did not penalize
the capital appreciation component of the stock. Instead, dividends
made a meaningful and additional contribution to McDonald's Corp's
exceptional total shareholder returns during this time period.

(click to enlarge)

Summary

Take away all the day-to-day noise associated with investing in
stocks and the stock market and you will discover that in the long
run fundamentals matter. In other words, inevitably shareholders of
stock in a publicly traded company will be rewarded in direct
proportion to how well the business performs on an operating basis.
The better the business does, the better the shareholders will be
rewarded.

The primary measurement of business performance is
profitability, otherwise known as earnings. It is earnings that the
market ultimately prices a stock by, and it is from earnings that
dividends are paid. However, it is our contention that the market
does not price the stock according to their dividend policy, they
price the stock according to their earnings power. Therefore, if
and when a company does pay a dividend, it represents a nice bonus
to total shareholder returns.

When we review the earnings and price correlated graph on Hormel
Foods Corp. (
HRL
) below we see that the black monthly closing stock price line
tracks the orange earnings justified valuation line. Furthermore,
we also see that, in fact, the market has tended to
more-often-than-not applied a premium valuation to this moderate
growing blue-chip. With this iteration, dividends have been
excluded from the analysis.

(click to enlarge)

With our next graphic we simply redraw the graph with dividends
(the light blue shaded area) added. Remember, our first graph and
this graph show the market applying a premium valuation. However,
the difference here is that we see how dividends, when they are
stacked on top of earnings, represent the additional return
dividends provide the shareholders. As you look at this graph and
the other dividend paying stocks included in this article, you
should keep in the back of your mind that the light blue shaded
area actually represents a cash payment to shareholders.

(click to enlarge)

Now as you examine the performance associated with the earnings
and price correlated graph above, note that capital appreciation
(closing annualized ROR) is almost identical to the company's
earnings growth rate. Therefore, all of the company's earnings are
being priced by the market, even those earnings that were paid out
in dividends. However, we can also clearly see how the dividends
represent the bonus this article has presented within its
thesis.

(click to enlarge)

Conclusions

We have long held that investing in common stocks is all about
investing in the underlying businesses. When looked at this way, it
is only logical to place more of your focus and attention on the
results of the companies you are invested in instead of worrying
about day-to-day variations in its market price. Because, whether
it is capital appreciation you are after, dividend income or both,
they are all generated by the profits from the businesses.

Regarding dividend paying stocks, it's great to get, as Will
Rogers so eloquently once put it, a return of your capital as well
as a return on your capital. The major object of this article was
to point out that dividend paying stocks are capable of providing
both a return of original capital invested and a return on your
money. On the other hand, dividend paying stocks are fully capable
of being great total return generators. From this perspective, we
see the dividend as a nice quarterly bonus. But whether dividend
paying or not, the principles of valuation must always be given
careful consideration.

Disclosure:
I am long [[MCD]]. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
this article.

Disclaimer:The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.

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